A Permanent Precedent

Martin Wolf

Thursday, 17 May 2012 | 10:49 PM ETFinancial Times

SHARES

The irritation of the eurozone with Greece is at extreme levels. After all, 80 percent of Greeks say they are in favour of staying in the euro, but then they fail to elect politicians prepared to implement the agreed programme. This drives creditors crazy. Increasingly, the latter are inclined to accept Greek exit, even welcome it. But they should be careful what they wish for.

Jorg Greuel | Getty Images

Greece

A departure would create severe dangers. The danger of contagion is obvious. The long-run danger is more subtle. But the eurozone either is an irrevocable currency union or it is not. If countries in difficulty leave, it is not. It is then an exceptionally rigid fixed-currency system. That would have two dire results: people would not trust in its survival and the economic benefits of the single currency would largely disappear.

These perils are not of concern to the eurozone alone. Taken as a whole, this is the world’s second-largest economy, with the largest banking system. The risk that a bigger eurozone upheaval would cause a global crisis is real. As frightening is the likelihood that eurozone crises would become permanent features of the world economy.

What, then, are the dangers?

Start with Greece. It is in a doom loop. Unemployment soared from 7 percent of the labour force in May 2008 to 22 percent in January 2012, while the unemployment rate of people aged under 25 jumped from 21 percent to 51 percent. Worse, despite fiscal austerity and debt restructuring, the International Monetary Fund estimates that gross public debt will be 160 per cent of gross domestic product in 2013, 50 percentage points higher than in 2008. Moreover, the IMF forecasts that the current account deficit – the balance of trade on goods and services – will be more than 7 percent of GDP this year.

Thus, the economy will be uncompetitive and depressed for years, if not decades. Not surprisingly, a dysfunctional Greek polity has collapsed. Politicians who believe they can obtain better terms are edging closer to power. This, in turn, creates a big potential dilemma for Athens’ outside supporters: either give Greece more money to alleviate pain, or stick to the programme and risk its collapse.

So what might a collapse entail?

As explained earlier in this series, a cessation of external official funding could trigger a disorderly collapse. The government would default. The European Central Bank would argue that Greek banks no longer possess good collateral, which would prevent it from operating as a lender of last resort. There would be comprehensive bank runs. Athens would impose exchange controls, introduce a new currency, redenominate domestic contracts and default on external contracts denominated in euros.

This would be chaos. Unpaid police officers and soldiers are unlikely to keep order. Looting and rioting could occur. A coup or civil war would be conceivable. Any new currency would depreciate and inflation would soar.

In the medium run, however, order might be restored. Assume Greece managed to bring its fiscal deficit under control, which is not inconceivable, since the IMF forecasts its primary fiscal deficit (before interest) at 1 percent of GDP this year. Assume its exporters were able to retain access to the European Union market. Then, as Arvind Subramanian of the Washington-based Peterson Institute for International Economics argues, Greece might enjoy a strong (though probably temporary) boom.

An orderly departure would end up in much the same place, sooner. Outsiders could support the banking system and pay beneficiaries of public spending during transition to a new currency. That should limit unrest as well as reducing the currency collapse and inflationary upsurge.

In a thought-provoking paper, “EMU Break-up: Pay Now, Pay Later”, Mark Cliffe of ING evaluates the consequences of a Greek exit. He assumes, first, that backstops for other countries would make such a departure a unique event. The result would be a manageable blow, with output falling 4 percent between 2012 and 2014 in Greece and up to 2 percent elsewhere in the eurozone, compared with forecasts that assume no break-up. But non-eurozone currencies would appreciate, with negative effects on their economies, as well.

Yet limiting the impact would not be easy. A Greek exit, particularly a disorderly one, is likely to trigger bank runs in Portugal, Ireland, Italy and Spain, and even further afield. It could also cause collapses in the prices of financial and other assets. A flight to safety, to Germany or beyond the eurozone, could accelerate.

The doom loop in which several other nations are caught could worsen substantially. Spain’s official unemployment rate was 24 percent in March, and its youth unemployment more than 50 percent. The IMF forecasts its general government fiscal deficit at just over 6 per cent of GDP this year. With real GDP contracting, its fiscal position is worsening rapidly: gross debt is forecast to increase from 36 percent of GDP in 2007 to 79 percent and rising this year. Yields on government bonds are more than 6 per cent. A further large rise in these rates would be unmanageable.

Adecisive response from the eurozone would be required to prevent severe contagion. The ECB would need to act as a lender of last resort on an unlimited scale, replacing money taken out in bank runs. Interest rates on sovereign debt would need to be capped by external measures, such as bond support schemes, and banking systems recapitalised. Above all, the commitment to keep the rest of the eurozone together must be reinforced. That would demand stronger forms of fiscal solidarity, probably eurobonds. Last but not least, the belief that countries can starve themselves back to health, in the absence of economic expansion and probably higher inflation in the core, would have to be abandoned.

Suppose that such efforts were not undertaken and the eurozone disintegrated. Mr Cliffe has sought to evaluate such an event. He concludes that the impact on GDP would be huge, not least on Germany. Thus, “in 2012 a deep recession across the eurozone emerges, dragging down the global economy. In the eurozone, output falls range from 7 percent in Germany to 13 percent in Greece. Individual country experiences would vary depending upon their exposure to foreign trade and financial interlinkages.”

Inflation would soar in the periphery; in core nations, deflation would set in. Inflation should erode peripheral nations’ debt mountains, provided they were promptly redenominated in the new domestic currencies. The value of the foreign assets of core countries would fall, their new currencies would soar relative to erstwhile partners and their economies shrink. It would be painful for all.

This analysis may even be too optimistic in its estimate of the impact of a full break-up. The mechanisms at work would be powerful: runs; the imposition of (illegal) exchange controls; legal uncertainties; asset price collapses; unpredictable shifts in balance sheets; freezing of the financial system; disruption of central banking; collapse in spending and trade; and enormous shifts in the exchange rates of new currencies. Further government bailouts of financial systems would surely be needed, at great cost. Big recessions would also worsen already damaged fiscal positions.

Such a break-up would also trigger legions of lawsuits. Beyond this, the EU would be cast into legal and political limbo, with its most important treaties and its proudest achievement in tatters. It is impossible to guess at the result of such a profound change in the European order.

What, then, would be the impact of such a full break-up on non-eurozone nations? The UK is heavily exposed on both the real and financial sides, and might suffer a 5 percent fall in output, says Mr Cliffe. Central and eastern Europe, too, would be hit. The US could suffer at least a mild recession, as could Japan.

Again, the wider ramifications of the implosion of Europe’s legal and political order are potentially even more significant. While unlikely to be as dangerous as the events of the 1930s, they could have incalculable consequences. If one accepts Mr Cliffe’s estimates, they would at any rate be worse than those of Lehman Brothers’ failure in 2008. This is perfectly plausible. The implication is that it cannot be allowed.

Yet a Greek exit would greatly increase the likelihood of such an outcome, both now and for the indefinite future, by showing that the euro is not forever. Every­body would then have to take into account at all times the possibility of break-up. If there were believed to be a serious risk of this, interest rates could explode across the board in weak countries. In such circumstances, moreover, activity-sapping fiscal austerity would not improve the attractions of the financial liabilities of weak borrowers but almost certainly reduce them, raising interest rates further.

These dangers would be heightened by a Greek exit, more still by a successful one. Thus, if Greece leaves, the eurozone will have to change fundamentally to make survival less painful and therefore more credible. If that is impossible, as many suppose, irrevocability must be seen as a mirage, which would in turn guarantee the repetition of large crises. It also destroys the economic arguments for the currency union by undermining financial integration and rendering long-term investments dependent on access to the entire eurozone economy far riskier. It is a nightmare.

Greek exit then would create a choice between big moves to a stronger union and a future of endless crises. It is a choice the dominant creditor nation, Germany, must make – among big steps to integration that horrify many of its people, a future of horrible crises or a horrible break up right now. No good choices exist. But the eurozone must become a stronger union or it will disappear.